The Formation of a Restaurant as a Legal Entity
15 Min Read By Julian A. Fortuna and Jonathan B. Wilson
According to the National Restaurant Association, among the more than one million restaurant locations in the United States:
• 7 in 10: Restaurants are single-unit operations.
• 8 in 10: Restaurant owners started their careers in entry-level positions.
• 9 in 10: Restaurant managers started their careers at entry level positions.
Each new restaurant opening creates opportunities for founders, investors and managers who should discuss various important matters with the lawyers, accountants and other professional advisors. Decisions that need to be made upon the formation of restaurant industry business include selection and formation of legal entity, financing, governance and insurance.
As with any other business start-up, a key question is what kind of entity to form. There are basically three choices:
(1) a corporation,
(2) a partnership, or
(3) a limited liability company.
A corporation allows the founders of the business to own shares in the corporation with no personal liability for the debts and obligations of the corporation, but they are limited in the way they could exercise control over the corporation through their ability to elect directors and have those directors appoint officers to run the corporation.
A limited partnership (LP) allows multiple investors to own a fraction of a new business by investing in the limited partnership entity. Those limited partners own a stake in the business and also have no personal responsibility for the debts and obligations of the partnership, but they have less ability to exercise control over the partnership. At the same time, to form a limited partnership, one of the partners (or another entity formed by one or more of the partners) must serve as the general partner of the limited partnership. The general partner has basic authority to run the business (subject only to those restrictions on the general partner’s discretion as might be negotiated and included in a limited partnership agreement) is liable for all the debts and obligations of the partnership.
Finally, a limited liability company (“LLC”), offers the limited liability and management flexibility of a corporation but as discussed below also offers the flexibility to be taxed either as a corporation, partnership or disregarded entity. Therefore, in many (but not all) cases an LLC will be the best choice of entity.
B. Tax Considerations
Each new restaurant opening creates opportunities for founders, investors and managers who should discuss various important matters with the lawyers, accountants and other professional advisors.
One of the chief reasons for entrepreneurs to select one form of entity over another is for tax efficiency: some forms require two levels of taxation while others “pass-through” income to investors for a single level of taxation. However, the tax rates vary based upon the type of entity chosen and there are circumstances where an entity subject to two levels of taxation may produce a lower overall tax charge than a “pass-through” entity. Also, in some cases the shareholders of an entity potentially subject to two levels of taxation may qualify for an exemption from the second level.
A corporation that has not properly elected to be taxed as an S-Corporation is sometimes called a C-Corporation. A C-Corporation is taxed on its net income on a stand-alone basis. The C-Corporation prepares and files its own tax return and, if it has net income, the C-Corporation pays tax on that income at the corporate marginal rate. The tax paid by the C-Corporation, however, has no effect on its shareholders. They recognize income and pay tax only on compensation or distributions received by them from the corporation. If, however, a C-Corporation distributes cash to its shareholders (i.e., as a dividend) the shareholders will recognize the cash received by them as income and will pay tax on that income as appropriate. As a result, a C- Corporation, unless it qualifies for special status, effectively has two levels of taxation.
In contrast, a partnership has only a single level of taxation. A partnership (whether organized as a limited partnership or a general partnership) is treated as a “pass-through” entity. The partnership provides each of its partners with a Schedule K-1, allocated to each of them their respective shares of partnership gain or loss. Each partner must thereafter recognize such gain as income (or such loss, if permitted) on the partner’s individual tax return. This pass-through treatment sometimes results in a more tax-efficient outcome for investors.
A third type of entity, known as an LLC, permits the owners to elect to be taxed as C Corporation or to elect pass-through tax treatment as a partnership or S Corporation but with added flexibility in other areas. If the LLC is owned by a single person it can be treated as a disregarded entity for income tax purposes. However, some tax benefits otherwise available to a C Corporation may not be available to an LLC that elects to be taxed as a C Corporation. For example, section 1202 of the Internal Revenue Code allows certain owners of “qualified small business stock” in a C corporation (but not an LLC that has elected to be taxed as C Corporation) to exclude up to $10 million of capital gains from the sale of such stock held for more than 5 years. However, this exclusion would, in any event, not apply to most restaurant industry businesses even if they were formed as a C Corporations.
On December 22, 2017, President Trump signed into law what has been referred to as the “Tax Cuts and Jobs Act” which will, in most cases, reduce the tax burden on restaurant industry businesses. At the same time, the new tax law makes the choice of entity and tax election decisions more complicated. Features of the new tax law that will be beneficial to many restaurant industry businesses include the following:
1) Reduction of highest corporate tax rate from 35 percent to a flat rate of 21 percent.
2) New deduction for 20 percent of “qualified business income” from a partnership,S Corporation, disregarded entity, or sole proprietorship.
3) Full tax expensing for cost of equipment and other qualified property, including used property.
On the other side of the coin, some restaurant industry businesses may discover that the following provisions in the new law will increase their tax burden:
1) Interest deductions limited to 30 percent of EBITDA for the next four years, then 30 percent of EBIT thereafter, but there is a small business exception.
2) Deductions for “excess business losses” limited to $500,000 (MFJ) and $250,000 (Single).
3) Net operating losses no longer may be carried back and annual future benefits from them will be limited to an 80 percent reduction in taxable income.
4) Slower depreciation for the cost of “qualified improvement property” generally defined as improvements to the interior portion of a building that is nonresidential real property. The slower depreciation (from 15 years to 39 years with no first year bonus depreciation), appears to be contrary to congressional intent and is likely to be remedied by a technical correction bill.
In summary, the tax considerations related to the initial choice of entity decision for restaurant industry businesses have become quite complex. These considerations will vary depending upon the taxable income projections contained in the business plan. For example, restaurant industry businesses planning significant capital expenditures that are likely to generate net operating losses and/or tax credits in the early years could benefit from pass-through treatment if the owners have other sources of income. In the future, when the business begins to generate taxable income, it could elect to be taxed as a C Corporation if such an election would produce a lower overall tax rate.
Many restaurant industry businesses are eligible for the “Work Opportunity Tax Credit” and/or the “FICA Tip Credit” both of which had been slated for repeal but were fortunately retained in the “Tax Cuts and Jobs Act” as well as various state tax credits. Restaurant industry businesses may also qualify for the new “Paid Family and Medical Leave Credit” and those located in certain geographic areas may also be entitled the “Empowerment Zone Employment Credit.”
Whether pass-through or C Corporation taxation would be more beneficial for a restaurant business generating positive taxable income would depend, in large part, upon the extent to which the owners could benefit from the new tax deduction for 20 percent of “qualified business income.” The calculation of the 20 percent deduction for qualified business income is beyond the scope of this article. In any event, entrepreneurs should always consult with tax counsel before making any decisions regarding the choice of entity and/or tax elections for their new and ongoing business operations.
C. Entity Governance
Corporations (whether taxed as C-Corporations or S-Corporations) are governed by a board of directors elected by the corporation’s shareholders. Corporations are creatures of state law, so the applicable requirements for a corporation’s board of directors and the manner in which board members are elected are stipulated in the corporate code adopted by the state in which the corporation is organized. Most state corporate codes, however, permit organizers some flexibility in stipulating the number of directors to be on the board and the manner in which those directors cans be elected by the shareholders. Most start-up corporations will cause their shareholders to enter into a shareholders agreement that obligates the shareholders to vote their shares so as to take advantage of provisions in the corporate code that allow the shareholders to determine their own systems of corporate governance.
In contrast to the form of shareholders agreement that the shareholders to a corporation might adopt, members of a limited liability company or partners in a partnership could draft the same concepts into the limited liability company’s operating agreement or the partnership’s partnership agreement. The language used to describe the contractual provisions would be mostly the same, substituting “partner” or “member” for “shareholder” as the case might be.
For limited liability companies or partnerships, however, placing these key governance, buy/sell and restrictive covenants in the company operating agreement or partnership agreement helps to make them enforceable on all the investors in the company. In comparison, because a corporate shareholders agreement only binds those shareholders who become a party to it, it is possible for a corporate shareholders agreement to bind fewer than all the shareholders. Operating agreements and partnership agreements, however, bind all of the members or partners in the company.
Another key concept involved in structuring new businesses involves the idea of a “preferential right” to distributions of operating income or distributions of proceeds in the event of a liquidation or sole of the company. Early investors will often negotiate for a preferential return of their capital, plus a return on that capital, and the way in which such a “preference” is documented varies by company format.
For corporations, preferential rights to distributions can only be accomplished through designations in the stock itself. This is usually done through a “designation of rights and preferences” that amends the corporation’s articles of incorporation, defining a particular class of stock and then specifying what its preferential rights should be. This can be cumbersome because the preference needs to be drafted in a generic way (i.e., by reference to the purchase price of the stock and without linking the concept to the identity of the stockholder) and because the designation of rights and preferences will be filed with the public filings of the corporation (generally in the office of the Secretary of State for the state where the corporation is organized).
Defining and documenting preferences is easier for limited liability companies and partnerships because they can be stated inside the operating agreement or partnership agreement. In nearly every state limited liability companies and partnerships have nearly unlimited flexibility in adopting preferences by writing them into operating agreements and partnership agreements. Because these agreements are private, and are not filed with any public record, the parties are free to describe their economic arrangements with any amount of detail, knowing that their deal will remain private.
Because of the flexibility made possible by the state laws creating limited liability companies and partnerships and their tax efficiency, most practitioners tend to favor limited liability companies and partnerships over corporations for small businesses and start-ups where the needs of the founders and the initial investors will require flexibility in governance along with tax efficiency.
D. Management and Succession
Structuring a new entity should involve the founders brainstorming over their idea with the assistance of counsel who has experience in forming new entities.
For most start-ups, where there is a desire to reduce legal expense, maintain simplicity and minimize taxes, a limited liability company will often be the best choice. The founders can be guided through a discussion of their plans and contributions, putting their thoughts into writing in an outline format. Some founders may be contributing time and efforts while other might be contributing cash or other assets. If the founders can outline all of their expectations and requirements, experienced counsel can usually translate that business outline into a draft operating agreement.
Experienced counsel can also raise all of the troublesome “what if” scenarios that optimistic entrepreneurs sometimes want to avoid. A well-crafted operating agreement, for example, should contain provisions for the continuation of the company after the death of one of the founders. The operating agreement should contain provisions for resolving disputes among the members. In some cases, dispute resolution mechanisms might involve procedures for a group of members to buy-out a recalcitrant member or a member who isn’t satisfying all of his or her obligations.
E. Insurance Concerns
Restaurant industry entities will definitely want to obtain both property and casualty insurance at an early stage in the process. Property insurance should cover the cost of replacing key items of equipment and personal property that will be used in the business. The cost of the insurance will generally be a function of the replacement cost of the equipment being insured.
Casualty insurance (often called “CGL” or “comprehensive general liability” insurance) pays the amount of any losses or claims made against the company by third parties who are injured by the company or its employees. For example, a patron of a brew pub who slips and falls, suffering an injury, could sue the proprietor for that injury. CGL would be the primary type of insurance that would potentially defend against or pay that claim.
While a comprehensive review of all the considerations involved when buying insurance is beyond the scope of this presentation, new business founders should consult with experienced counsel before making a purchasing decision. Insurance policies are not all alike and experienced counsel can guide entrepreneurs through many of the key issues. The amount and types of insurance can also vary based on the nature of the business and other factors. For example, a company that is leasing space may be required by its lease agreement to maintain certain types or amounts of insurance. Similarly, large commercial contracts (such as a distribution agreement with a distributor or reseller who will sell the company’s products to retailers) may also require certain types or amounts of insurance. Often, these third party contracts will also require that the third party be named as an “additional insured” or a “loss payee” in the insurance policy. Experienced counsel can identify these concerns and address them as party of the insurance purchasing process.
If the new business is going to have a board of directors (either because it is a corporation or because it is a limited liability company that has determined to be governed by a board) the company should consider whether to obtain directors and officers (or “D&O”) liability insurance. A D&O policy will pay the costs of defending (and sometimes pay the judgment or settlement amount) claims asserted against individual officers or directors of the company. D&O insurance is relatively inexpensive and, because of the enormous expense involved in defending an individual against a suit, is often worth the premium paid for the assurance it will provide to the individuals who will be running the company.
F. Financing Challenges
The process for raising funds for a new venture has always been challenging as it involves the application of securities laws to the process followed by new business founders in trying to solicit investors. Securities laws are complex and entrepreneurs should be cautioned against trying to raise funds or sell a stake in their business without having experienced counsel involved.
In recent years, several changes in U.S. securities laws and the hype surrounding “crowdfunding” has made entrepreneurs focus more on the process of fundraising, even as the proliferation in types of fundraising has made the process more difficult.
The idea of “crowdfunding” has been in the news a great deal but investors have only just begun to realize its potential for the restaurant industry. Crowdfunding is the idea that a large number of people, with no particular expertise, can accurately predict the likely success or failure of a venture by combining their own observations and communicating with each other. James Surowiecki, in his book, The Wisdom of Crowds, recounts dozens of examples where a large group of people who were able to collect and share information were able to make more accurate guesses about the success of a project than the best guess of any individual expert in the topic. The Internet, with its ability to collect a large number of people quickly and easily, makes it possible to collect a “crowd” to evaluate an idea better than was ever possible before.
Crowdfunding applies this idea to the process of evaluating investment opportunities, allowing members of the crowd to put money behind their predictions and preferences. Proponents believe that by allowing a crowd of potential investors to share their opinions about the investment and the information they collect that crowd will be better able to predict the success of the investment than individual investment experts.
Crowdfunding can take several forms. Popular crowdfunding sites like Kickstarter and Indiegogo let project sponsors describe their projects to the public and ask for donations. In an “affinity” campaign, supports of a project pledge funds for a project because they like it and support it. Their affinity for the project is their only reward. In a “rewards-based” campaign, project sponsors offer rewards for cash contributions. Rewards may range from recognition on a website or on a wall, to t- shirts, products samples and more. Promoters of restaurants, brew-pubs and distilleries should take care, however, when pursuing “rewards-based” campaigns for their projects as many states have prohibitions and restrictions on discounts or promotions based on sales of alcoholic beverages.
In mid-2014 Kickstarter estimated that it had been involved in 323 crowdfunding efforts for restaurants. All of those efforts were rewards-based as government rules for securities-based crowdfunding were not completed in 2014. Since then, several kinds of securities-based crowdfunding have become possible in which project sponsors are able to sell securities (which can be equity securities, like stock or debt securities, like a promissory note) to investors.
What makes both rewards-based and securities-based crowdfunding intriguing for restaurants is the way they can combine a community’s natural support for a venue with the community’s profit motive. By attracting an online community that is financially committed to helping a new venture succeed, the promoter is not only attracting customers who will be committed to patronizing the restaurant but also enlisting those same customers to become part of a viral marketing process to invite their friends and neighbors to join them.
Securities-based crowdfunding is possible through several recent changes in U.S. securities laws, most of which are derived from the 2012 Jumpstart Our Business Startups Act (or “JOBS Act”). Among other innovations, in one of the biggest changes to securities law since 1933, the JOBS Act intended to make it possible for small businesses and start-ups to solicit investors directly – in person and on the Web – to make investments in their companies.
In particular, the JOBS Act created three types of crowdfunding: (a) crowdfunding to “accredited investors” under Rule 506(c), (b) crowdfunding for up to $50 million each year under new Regulation A+ and (c) crowdfunding to both accredited and non-accredited investors in small offerings under Title III.
Investing Under Rule 506(c)
First, a sponsor could offer debt or equity securities to “accredited investors” under Rule 506(c). The JOBS Act changed some of the rules affecting private offerings under Rule 506 so that sponsors could publicly-advertise their offerings. Before this change in the law, public solicitations of private offerings were strictly prohibited. Under new Rule 506(c), however, a promoter that wants to advertise publicly may do so if it takes steps to ensure that every investor who participates is “accredited”, which is defined as having a net worth of over $1 million (excluding the investor’s principal residence) or having an income of more than $200,000 for two consecutive years ($300,000 is the investor is married and files tax returns jointly with a spouse).
Crowdfunding under Rule 506(c) has been feasible for more than a year and several websites, including Circle Up and EquityEats have had some success hosting crowdfunding campaigns that have included securities under Rule 506(c). EquityEats, in particular, has followed a two-part approach for new restaurant startups. For a restaurant that exists in concept only and has not yet launched, EquityEats will allow the sponsor to solicit cash from backers in exchange for food and beverage credits. Backers can voice their support with a monetary pledge, but no funds change hands until the campaign reaches its financial goal. This way, backers can be assured that they won’t be contributing funds to a project that will never get launched. After a project reaches its initial goal so that the restaurant launches, EquityEats allows a second phase in which the sponsor may sell securities under Rule 506(c).
Johann Moonesinghe, Chief Executive Officer of EquityEats explains that the average restaurant requires roughly $250,000 in cash to open its doors, with that number doubling in big cities, Moonesinghe says. “A crowdfund offering for, say, $100,000, is often the last big of capital required to push a project over the edge.”
Investing Under Regulation A
Another legal change that came from the JOBS Act was a change to Regulation A, an SEC rule that allows a private company to qualify its securities through a formal prospectus filed with the SEC. The SEC reviews the prospectus to ensure that it adequately describes all of the risks of the business and the risks to investors. Once the issuer’s prospectus is approved by the SEC (at which point it is said to be “effective”) the sponsor may sell the securities to both accredited and non-accredited investors. Before the JOBS Act, offerings under Regulation A were limited to not more than $5 million. Under the new provisions of Regulation A (sometimes called “Regulation A+”) an issuer of securities may raise up to $50 million in any 12-month period.
One of the advantages of a Regulation A offering is that the company will be able to solicit investments from both accredited and non-accredited investors, thereby widening the scope of interest in the project. These changes to Regulation A, however, have only been effective since October 2015, so there have been relatively few offerings that have completed the new process and it is hard to predict whether these new offerings will be accepted by investors.
The third possible route for crowdfunding is often called “Title III” because it arises under Title III of the JOBS Act. Although the JOBS Act became law in 2012, the SEC only released its rules implementing this new law in October 2015 and those rules didn’t take effect until May 2016. Under those rules, a promoter may issue securities, in an amount up to $1 million in any 12-month period, to both accredited and non-accredited investors. But, soliciting for investors may only take place through licensed crowdfunding portals that have received a license from the Financial Institutions Regulation Authority (“FINRA”).
Under Regulation CF (the name used for the SEC’s Title III regulations), issuers do not file a prospectus with the SEC but must make specified disclosures about the company in their offering memorandum. The funding portal is also required to ensure that all prospective investors receive certain notices about the process and that each investor invests no more than a certain maximum that is derived from the investor’s taxable income.
Investors in a Regulation CF offering may not invest more than (a) the lesser of $2,000 or 5 percent of their net worth (if their annual income is less than $100,000) or (b) the lesser of $100,000 or 10 percent of their net worth (if their annual income is more than $100,000).
While a Regulation CF offering can “go national” by accepting investments from people across the country (whether they are accredited or not) the $1 million limit and the requirement that all solicitations take place online through the licensed portal make this approach a challenge for many new ventures.
Founders, managers and investors in restaurant industry companies should seek advice from lawyers, accountants and other professionals well before opening a new restaurant business.
About the Authors
Julian A. Fortuna is a partner at Taylor English in Atlanta where he focuses his practice on domestic and international tax planning and tax controversy matters. His industry experience spans clean energy, entertainment, health care, higher education, hospitality, manufacturing, non-profit, real estate and retail.
He can be contacted at firstname.lastname@example.org.
Jonathan B. Wilson is a partner at Taylor English in Atlanta. He is an experienced business lawyer who enjoys solving complex business and transactional problems for clients. His practice includes corporate securities, corporate finance and governance, mergers and acquisitions, and intellectual property.
He can be contacted at email@example.com.